LONDON/MILAN, Feb 2 (Reuters) - A group of hedge funds have stepped up bets against a string of Italian banks, taking a contrary stance against a sector and broader market on the rise ahead of an election which could yet rattle investors.

The negative stance, shown in positioning data filed with the regulator, is at odds with business morale - at a decade high as a slow economic recovery gathers pace - as well as debt markets, where there is no sign of sovereign stress ahead of the March 4 vote.

Italian banking stocks - a proxy for the health of the wider Italian economy, have risen 11 percent so far this year to push the country’s FTSE MIB index up 6.5 percent, outperforming most European peers.

By contrast, European banks have risen just 3.8 percent over the same period.

While Italy’s market gains have been helped by growing confidence over the country’s economic recovery, thanks in part to the European Central Bank’s loose monetary policy, banks would be firmly in the firing line if the market suddenly considers the positivity overdone, such as around the election.

At the moment, the anti-establishment Five Star Movement is the most popular single party in opinion polls, ahead of the ruling party PD. A centre-right alliance of smaller parties is seen winning most seats in parliament though, but probably not enough to govern, pointing to a coalition.

“It’s a paradox,” said Carlo Franchini, head of institutional clients at Italy’s Banca Ifigest, about the relatively sanguine market reaction so far.

“People simply haven’t realised there are elections ahead. The problem is the immense liquidity,” he added, referring to how easy money policies have inflated bond prices in the heavily indebted euro zone country.

So-called ‘short’ bets on lenders including UniCredit , BPER Banca and Credito Valtellinese have all risen since the end of last year, data from the Italian regulator’s website showed.

The hedge fund trade involves borrowing a stock from a long-term holder such as a pension scheme and selling it into the market in an expectation that the price will fall before you buy it back and return it, pocketing the difference as profit.

U.S. hedge fund Bridgewater Associates is leading the charge with the largest number of bets in the sector, including against Intesa Sanpaolo, UniCredit and Finecobank, among others.

All of the funds involved in shorting Italian banks either declined to comment or were not immediately available to comment when contacted by Reuters.

BULLS

Not everyone agrees, however, particularly as the Italian banking system begins to tackle its large pile of non-performing loans, freeing up cash to lend to companies and boost economic growth.

Investors also see potential for the fragmented Italian banking system to consolidate and cut costs.

A spokesman at one London-based fund told Reuters his firm was “rather positive” on Italian banks. “We think they are very cheap and they have addressed their issues.”

Jerry del Missier, who runs hedge fund and private equity firm Copper Street Capital, said he had a more nuanced view on the Italian banks.

“There are clearly capital challenges at a number of institutions but good progress was made in the last year in cleaning up the sector. Some of this has been reflected in the market already, but we believe there are still attractive valuations across the capital structure of several banks.”

Six hedge funds owned stakes in UniCredit, betting the share price would rise, according to Thomson Reuters data, while three held such positive bets in BPER Banca and three in Credito Valtellinese.

The International Monetary Fund estimates the Italian economy grew 1.6 percent in 2017, the strongest rate since 2010. The economy is set to grow 1.5 percent in 2018, lagging average growth of 2.2 percent across the whole euro zone.

The stock market was helped in 2017 by 11 billion euros of investment from a government-backed scheme to promote public ownership of small and mid cap companies. Another 9 billion euros investment is expected in 2018, according to estimates from brokerage Equita. (Editing by Elaine Hardcastle)